Turmoil. Volatility. Confusion. The words used in the press to describe the current situation on the Chinese stock market make for a worrying read. Just what is happening in the world’s second largest economy, and should we be concerned?

Off to a shaky start

Reuters called it a “brutal start to 2016”: hours into the first day of trading, and Chinese stock prices had fallen so steeply that officials were twice forced to apply their new – and short-lived – circuit breaker, which dictated that trading would close when prices fluctuated too dramatically.

The Shanghai Composite ended the first day of trading down by nearly 7%, and stock markets around the world followed suit. In the US, for example, the Dow finished down 276 points – its worst opening trade day in almost a decade.

Source: Bloomberg

The bad news continued throughout the week. On the Thursday, trading on Chinese stock markets was again halted after barely 30 minutes, when panic selling and an attempt to beat the circuit breaker saw shares fall by 7%. The first week of trading ended with global markets in tumult. And this might just be the start: “Many investors are bracing for higher levels of volatility in stocks in the weeks ahead,” the Washington Post warned yesterday.

What’s behind it all?

So what triggered such a bad start to the year? Some have pointed the finger at China’s manufacturing sector, which has been shrinking for the past five months. A report released a few days before the first day of trading confirmed this. This weak economic data follows a year of slower growth in China, which has spooked some investors.

Source: Quartz

Ironically, the circuit breaker – the very measure meant to halt any volatility – might have made things worse, as traders rushed to sell off shares for fear of being locked out by the automatic trading shut-down. In what has been described as a dramatic U-turn, Chinese authorities abandoned the mechanism last week, but not before the chaos it caused had wiped billions off stock markets around the world and sent commodities tumbling.

A longer-term trend

It’s not the first time in the past year that China’s stock market has been making headlines for the wrong reasons. In August, stocks on the Shanghai Composite dropped by 8.5% in just 24 hours – its worst one-day fall in eight years. Commodities and global stock markets followed, with oil prices hitting a six-year low.

Last summer’s stock market woes were partly caused by a Chinese currency devaluation – the first in 20 years. At the same time, cheap cash and a sluggish property market led some investors to look for alternative assets, creating a bubble.

But for all the hype in the media, could we be reading too much into this? Some are already calling for a little perspective: “China’s stock market is still small enough that what happens in it doesn’t really matter for its economy,” points out Matt O’Brien of the Washington Post.

For Jennifer Blanke, the Forum’s chief economist, while the volatility is of course alarming for investors, it could actually be a sign that China is moving in a new direction: “In many ways, the recent volatility is the result of China moving towards a more normal and less interventionist system. There are fits and starts as the regulators try to get it right, and this is to be expected in such a transition. As long as the process towards less interventionism continues, I believe we should be cautiously optimistic that this is a positive long-term development for the sustainability of the Chinese economy.”

Many analysts have a similarly positive view of events on the Chinese stock market, noting that the Shanghai Composite still outperformed the S&P 500 in 2015 and finished 9.4% higher than at the start of the year.

Source: Thomson Reuters Datastream/Fathom Consulting

Should the rest of the world be worried?

“If the dragon sneezes, the world gets a cold,” writes Wu Xinbo of Fudan University in an upcoming Forum report on China and the global economy. Put simply: what happens in China affects the rest of the world. Now more than ever.

That’s why, despite the many calls for calm, investors and policy-makers everywhere are anxious to see what will happen next – and it’s one of the topics they’ll be discussing on a livestreamed panel in Davos later this month. To be continued.

Now watch the Davos 2016 session China's Business Context.